We’ve all heard the same thing over and over about real estate. A home is your biggest investment, or if your rent is the same as a mortgage, just buy a home?!! If you’re not a homeowner, then you’re just throwing your money away on rent! Lifehacker showed that’s a false mentality!
We all have a million questions about money. A big one is how do you know if you’re ready to buy a home?
Ask Carly is a way for us to stay connected and support one another on our journey to gaining financial independence. You don’t need to figure this money stuff out on your own. You can submit your questions about life and money here.
Mario wrote in with a dilemma, or shall we say proposition about buying a home.
He wrote:
Carly,
I’m thinking of buying a home. I was wondering what your thoughts were in potentially investing in a home and using rental income to pay off another debt. I’d stay on the property but have space (basement/backhouse) for a renter. Also, what kind of financial indicators makes someone ready for a home? I feel like I have a pretty good debt-to-income ratio to get financing, but the idea of having such a large number over my head for so long is a little nerve-wrecking.
-Mario in Nebraska
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Here’s simple indicator of how do you know if you’re ready to buy a home:
How much money have you saved for the home?
Or as Jerry Maguire says, “SHOW ME THE MONEY!!”
Yes, you can “purchase” a home with little to no down payment, but hello 2008, and the mortgage crisis, clearly that’s not the best idea!
Home values don’t always rise, and you do want to have equity in your property. A standard rule of thumb is to have a down payment of 20% or more the value of the property.
Why 20%? Well, because if you have lower than 20% down you’ll have to pay an extra insurance called Private Mortgage Insurance, or PMI. This is then about .5-1% the value of the loan.
For example, Mario, being in Nebraska the median price of homes listed for sale is $190,000, a 20% down payment is then $38,000.
If the down payment is lower than $38,000, then annually he’d spend up to $1900 for PMI.
Now, we’ve covered the basics, let’s dig into the part about using real estate to payoff other debt.
I created The Ultimate Guide to Managing Money with a step by step process for investing, getting out of debt, saving for emergencies, and buying a home or car. It’s your step 1, 2, 3, and 4 with money. You can get your free downloadable guide here!
How do you know if you’re ready to buy a home?
Step:1 Save 10% of your pay.
Before you buy a home, have you been investing consistently for retirement? Be smart with your money by investing for retirement now. See your money compound and grow.
When paying off any debt of the 10% you are saving, save 5% for an emergency fund (liquid savings), and 5% for retirement (long-term investing).
Step 2: Get out of debt.
It’s counter-cultural to pay off debt before buying a home. However, as Mario pointed out even if he’s making an income from renting out the basement, it is nerve wrecking having debt over your head.
After automatically saving a percentage of your pay, then focus on paying off all your student loans, car loans, credit cards, ‘I owe you’s’ and so forth.
Often people have debt and buy a home by using practically every last penny they have for the down payment, moving costs, and closing costs. Closing costs are 2-5% the value of the property, which in this example would be an additional $3800-$9,500.
Then instead of building wealth through real estate they find themselves in more debt, and often confused? Thinking, “I thought this was investment, but I’m handing over my credit card number to pay for this $4,000 a/c that I’ve gotta repair because its 107 degrees outside.”
I highly encourage Mario, to buckle down and get out of debt the good ol’ fashioned way… rolling up your sleeves and paying $300 or more each month to the highest interest debt. Once the highest interest debt is paid, take that minimum and the extra $300 to pay towards the next highest interest debt, so and so forth until you are debt-free.
Phew, that was a LOT of information. We’re not done just yet.
When he’s debt-free, then he’ll start investing all 10% towards retirement.
Step 3: Save for 3-12 months of expenses for an emergency.
Now that Mario is debt-free this is where it gets fun!! What was once a liability, his debt payments and the extra $300 per month, will now be an asset, or shall we say MONEY MACHINE!!!
In other words, what he was putting towards debt is now his, and he can save for a rainy day… like that A/C going out, or who knows what. Think: car accidents, job loss, ER visits, etc. Having an emergency fund is a great indicator that you are prepared for the maintenance and upkeep for a home. Here’s an easy guide to emergency funds.
Step 4: Save for life purchases like buying a home or car.
Hello life. Now Mario is sitting pretty. His retirement savings is off to a great start, his debt is paid in full, he has money in the bank for a rainy day, and now the sky’s the limit. With no monthly debt payments, he can save up and have a plan for the fun things in life, like buying a home!
What he was paying towards his debt, plus the extra $300 can be used to save towards a home. Having a lofty down payment in addition to having an emergency fund is a financial indicator that he’s ready to buy a home.
I would like to say, YES go buy a home! Do it now!! But, sometimes wonderful things in life are worth waiting for.
P.S. Want more? You’re invited to join me for the next Best Money Class Ever. It’s a 4-week personal finance class that is like CrossFit, but with money. Learn more on how to get out of debt, invest, and manage your money. You can view the class live in Austin, or online. Get the details here.
